Consumer prices may ease soon despite drought-driven spike

The Drought-stricken corn grows in Missouri Valley, Iowa. Corn prices have soared to record highs.

Though severe drought conditions have raised the cost of food this summer, consumers may have seen the worst of the price impact at the grocery store.

Higher food prices helped lift the closely watched Producer Price Index by 0.3 percent in July, the fastest pace in five months. At the same time retail sales rose 0.8 percent, the first increase in four months and well ahead of expectations, signaling that the sluggish economy may be picking up momentum.

The increase in producer prices was driven in part by a jump in light truck prices, up 1.6 percent, and pharmaceuticals, up 0.9 percent. At the grocery store, wholesale prices rose a sharp 0.5 percent in July, on top of the same price rise in June. Over half that jump resulted from higher prices for beef and veal, which climbed 3.8 percent, according to the government.

But with livestock producers facing steep increases in the cost of feed grains, the rise in meat prices may soon reverse course, according to Michelle Girard, an economist at RBS.

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“Because it's so much more expensive to keep them and feed them, you may actually get more cattle being brought to slaughter, so beef prices may actually in the very near term have downward pressure," she said.

To help slow that price drop, and cushion the drought's impact on livestock producers, the White House announced Monday that the federal government will buy $170 million of meat and poultry. The increased demand generated by the government will help offset the expected glut of supply as livestock producers rush their herds to slaughter to avoid spiking feed costs.

Corn and soy harvest forecasts were slashed last week after the worst drought in 50 years destroyed millions of acres of crops. Corn prices last week hit record levels of nearly $9 a bushel. Wheat and soybeans also hit multiyear highs.

But those spikes are expected to ease as demand eases, beginning with those livestock producers who are trimming herds. Ethanol producers facing soaring corn prices have also scaled back production.

Rising crop prices have also spurred foreign plantings in recent years, which may blunt the impact of this year’s shortfall in the U.S., according to a recent report on the drought's economic impact from the Federal Reserve Bank of Kansas City. Since 2003, for example, the former Soviet Union has added 48 million acres of crop production and South American nations have planted an additional 42 million acres, according to the report.

“High prices could entice further expansions in global production that could lead to lower prices,” the report said. “The best cure for high prices might be high prices.”

U.S. consumers will also be shielded from the recent sharp spikes in grain prices because the cost of those raw materials make up a relatively small share of the overall price of finished food products. Commodities like corn and wheat make up roughly 14 percent of the retail cost of food, according to the USDA. The rest of the price posted on the supermarket shelf represents processing, packaging, shipping, marketing and other production costs.

The Kansas City Fed report estimates this year’s drought could add about 4 percent to retail food prices next year. Since the cost of food makes up about 14 percent of the Consumer Price Index, the drought would contribute just 0.6 percent to overall inflation, according to the Kansas City Fed economists.

Consumers facing higher food prices are also getting some relief from a recent fallback in gasoline prices. Energy prices fell 0.4 percent in July for the fifth month in a row, according to the government’s inflation report. Wholesale gasoline prices fell 3.1 percent last month.

The summer surge in corn prices has sparked calls for a waiver of the government‘s mandates and subsidies promoting corn-based ethanol. Some 40 percent of the U.S. corn crop is diverted to produce the gasoline additive, which raises fuel octane and lowers air pollution.

But a waiver of those mandates appears unlikely – largely because refiners would be hard-pressed to cope with a shortfall in ethanol production.

“Our gasoline logistics and distribution system is so entrenched with ethanol that we need it and very difficult for the refining system to change," said Andy Lipow, president of Lipow Oil Associates.

With no end in sight to the parched conditions, areas and businesses hardest hit by drought are already feeling the economic impact. But overall losses in the farm belt are expected to be reduced by the widespread use of federal farm insurance, which covers farmer’s losses from crop failures.

So the overall economic impact of this summer’s crop shortfall is expected to knock less than a tenth of a percent off gross domestic product, according to Paul Dales, economist at Capital Economics.

“This is clearly not a disaster for the total economy, but when growth is just 2 percent every little bit counts,” he said.